Faced with the increasing risk of global stagflation, is there a solution?

Published 01.07.2018 21:27

The inflationary pressure caused by escalating trade wars around the globe is one of the hottest topics of the past few days. The $200 billion tariff war between the U.S. and China in particular put more pressure on financial markets instead of manufacturers.

The world economy has increased growth rates to 3-6 percent with market trends based on demand. Rising commodity prices triggered by strong demand caused the Bloomberg Commodity Index, which includes Brent crude oil and copper along with 20 other raw materials, to reach its highest rate since November 2014. The tariffs imposed by the U.S. in an attempt to halt China's increasing import volume is pressuring economies dependent on low cost raw materials such as Europe and developing economies.

Rising commodity prices which surpassed expectations in U.S. domestic markets as a result of tax cuts introduced by U.S. President Donald Trump are seen as a major problem. Meanwhile, Beijing is worried about rising energy costs while it successfully lured high liquidity into the country after Chinese manufacturers took long-term credits. With the U.S. renewal of Iran sanctions putting China's oil deal with Iran at risk, finding alternative energy sources may result in a major headache for China in 2019.

A nominal increase in U.S. dollar exchange rates and increasing energy prices brought about the risk of stagflation. The effect of the dollar's global free circulation on the growth rates of developing economies between 2003 and 2015 can't be denied. Countries that turned to consumerism with cheap labor, easy access to funds and low interest rates now face heightened difficulties with the end of Keynesian policies and the Federal Reserve's increasing risk aversion.

The rise in inflation, despite high interest rates, is not because of increased demand but rather due to increasing manufacturing costs. Stagflation, which appears when manufacturing costs exceed revenue, can be called a simultaneous combination of recession and inflation. It is a challenge for governments to deal with the risk of possible bankruptcy while promoting growth in the economy. The underlying causes of the current situation were inflation and the attempt to balance real interest rates. This especially put countries like China and Vietnam under significant pressure. For example, China had to add a 10-12 percent real interest rate risk to an already existing 12.5 percent inflation to achieve 8 percent inflation, which in turn caused a 25 percent policy interest, making increasing growth while reducing inflation an impossible task.

Implementing a medium-term development plan to improve the economy, China managed to reduce policy interest rates by combining an influx of foreign currency with export-focused manufacturing. With capital staying within China, the government managed to open up new manufacturing plants around the country, thereby reducing unemployment rates. The critical part in this plan was that for the first five years, China's exports always exceeded its imports. If the reverse of this were to happen, inflation would become unmanageable, rising despite low real and policy interest rates.Therefore it is possible to manage both policy interest rates and inflation at the same time, but only with a strict financial policy and export-focused manufacturing. Otherwise, the dilemma of stagflation is unavoidable.

Of course, this success story has other contributing factors. First of all, energy and Brent oil prices were stable during those times when global economic growth was slow. An increase in energy prices while the Group of Eight (G-8) countries maintained 6-8 percent growth would not affect developing economies as drastically as it would today. The main reasons for this are high volumes of currency in circulation and foreign investors choosing to invest directly with interest yield expectations.

Second, growth should not focus on domestic demand. An increase in imported goods and commodities will affect manufacturers first. Manufacturers that can endure increased costs will increase prices, which in turn will cause demand to decrease, triggering an rise in policy interest rates despite initial reduction in inflation, due to high finance charges and unemployment rates. Careful attention shows that global inflation is priced alongside real policy interest rates, independent of supply and demand. Basic consumption goods, energy needs and the private sector apply absolute pressure on policy interest rates.

With the tariff war between the U.S. and China, sanctions on Iran and the possibility of Italian banks defaulting, dark clouds loom over global markets these days and the playing field for central banks around the world has narrowed considerably.

* Ph.D. researcher at the Swiss Business School's Private Company Economic Research Department (MENA)

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